3/27/2009 @ 5:00AM

China Resumes Dollar Pegging On The Sly

Even while calling for a global substitute for the dollar’s reserve currency role, Beijing has essentially returned the yuan to a dollar peg, a policy it formally abandoned back in 2005 in favor of multiple foreign currency reference points. So, while Washington frets over the apparent halt in the yuan’s progressive appreciation, economists say that China has actually taken measures to keep the yuan from falling against the dollar, by shifting its exchange rate regime back to tracking the dollar since the global financial meltdown began.

As currency-related sniping heated up with the Obama administration this week, economists were wondering why Beijing did not allow the yuan to depreciate. That would be the economically rational thing to do, so as to prop up the country’s troubled export sector in the face of the global demand slump. It would also be the logical outcome of China’s declared exchange rate scheme. The backdrop of rising global protectionism notwithstanding, U.S. political pressure may be a motivation, they suggest.

China sets the yuan’s value based on a narrow range of fluctuation against a basket of currencies, including the dollar, euro, yen and won, and does not disclose the different weights assigned to each currency. But through some sophisticated statistical methods, the change in the weighting of each foreign currency over time can be inferred. What Harvard economist Jeffrey Frankel has found is that, after Beijing de-pegged from the dollar in 2005, the yuan eventually became equally weighted between the dollar and the euro. In fact, the yuan’s 20% appreciation against the dollar over the next three years to 2008 mostly reflected the euro’s gain vis-a-vis the dollar.

But, as the global financial crisis unfolded and the dollar began to rebound against the euro, Beijing started by May 2008 to move the yuan back toward giving primary weighting to the dollar, a move that prevented it from backsliding relative to the greenback. In fact, in the period from September 2008 to February 2009, Beijing’s currency regime “has come full circle, virtually back to what it was in late 2005,” said Frankel, who is the director of the Program in International Finance and Macroeconomics at the National Bureau of Economic Research. A Wednesday report by Morgan Stanley similarly observed a “new renminbi [yuan] regime featuring a quasi-hard-peg to the U.S. dollar.”

Since China weathered a whopping 25.7% drop in its February exports and faces the headache of 23 million unemployed migrant workers on its hands, it would have made more economic sense for Beijing to let the yuan depreciate to make its exports cheaper abroad. “The economic rationale for that is quite compelling. Why isn’t it happening? One explanation is that it would be seen as inflammatory in an already troubled international trade environment,” observed CLSA chief economist Eric Fishwick. “U.S. politicians would indeed have complained loudly,” Frankel remarked. “Then again, they will do that either way.”

There are other possibitilies: Beijing wanted the “security blanket” of dollar pegging during last year’s financial crisis, or its officials had actually expected the dollar to fall since the crisis started in the United States, Frankel noted.

For now, with dollar depreciation on the horizon as a consequence of Washington’s profligate spending, Beijing again faces two currency options. It could let the yuan continue to shadow the dollar and thus depreciate against the rest of the world, “easing domestic monetary conditions,” according to Morgan Stanley. Or it could shift the yuan away from the dollar, avoiding a further U.S. outcry. China currency watchers are keeping an eye out.